Finance Management Accounting the Agile Manager's Guide to Understanding Financial Statements

7/26/2019 Finance Management Accounting the Agile Manager's Guide to Understanding Financial Statements

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The Agile Managers Guide To

UNDERSTANDING

FINANCIAL STATEMENTS


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The Agile Managers Guide To

UNDERSTANDINGFINANCIAL STATEMENTS

Velocity Business PublishingBristol, Vermont USA

By Joseph T. Straub


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Copyright 1997 by Joseph T. Straub

All Rights ReservedPrinted in the United States of America

Library of Congress Catalog Card Number 97-90831

ISBN 0-9659193-5-8

Title page illustration by Elayne Sears

Second printing, April 1999

If youd like additional copies of this book or a catalog of

books in the Agile Manager Series, please get in touch.

Write us:

Velocity Business Publishing, Inc.

15 Main Street

Bristol, VT 05443 USA

Call us:

1-888-805-8600 in North America (toll-free)1-802-453-6669 from all other countries

Fax us:

1-802-453-2164

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[email protected]

Visit our Web site:

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The Web site contains much of interest to business peopletips

and techniques, business news, links to valuable sites, and instant

downloads of titles in the Agile Manager Series.

Velocity Business Publishing publishes authoritative works of thehighest quality. It is not, however, in the business of offering profes-sional, legal, or accounting advice. Each company has its own cir-cumstances and needs, and state and national laws may differ withrespect to issues affecting you. If you need legal or other advicepertaining to your situation, secure the services of a professional.

For Pat and Stacey
http://agilemanager.com/http://agilemanager.com/


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Contents

Introduction ......................................................................... 7

1. Financial Statements:

Who Needs Them ........................................................... 9

2. Understand the Income Statement ............................... 17

3. Understand the Balance Sheet ...................................... 27

4. Understand the Cash-Flow Statement .......................... 37

5. Financial Analysis:

Number-Crunching for Profit ...................................... 45

6. Inventory Valuation

(Or, Whats It Worth?) ................................................... 67

7. Depreciation .................................................................. 77

Glossary .............................................................................. 85

Index .................................................................................. 93


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Books in the Agile Manager Series:

Giving Great Presentations

Understanding Financial Statements

Motivating People

Making Effective Decisions

Leadership

Goal-Setting and Achievement

Delegating Work

Cutting Costs

Influencing People

Effective Performance Appraisals

Writing to Get Action

Hiring Excellence

Building and Leading Teams

Getting Organized

Extraordinary Customer Service

Customer-Focused Selling

Managing Irritating People

Coaching to Maximize Performance


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Introduction

It happens.Youre at a meeting, and the boss looks right at you and says,

Whats the ROI on that product again?

You gulp, trying desperately to remember what ROI means.

You search your mind for the R. Revenue? Ratio? Return?

You have no idea. Rats. Turning red, you mumble, Gee, I dont

know offhand. I can get back to you, though.

The boss stares at you a few seconds before changing thesubject. He doesnt even have to say it out loud: I expect you to

know these things.

Or youre in a job interview, and the interviewer is testing

your facility with numbers. The job requires a passing ability

to make sense of the departments finances. Nothing too diffi-

cult. Take a look at these for a few minutes, she says, shoving

what appear to be financial statements in front of you. Whenyoure ready, tell me what the debt-to-equity ratio is. And while

youre at it, the current ratio and return on equity. She gives

you a quick smile, as if it were the easiest thing in the world to

pull those figures off the papers in front of you.

7


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8 THEAGILEMANAGERSGUIDETOUNDERSTANDINGFINANCIALSTATEMENTS

Actually, coming up with those figures is one of the easier

things to do in the business world. Once you become acquainted

with such things as the income statement and balance sheet, thenumbers leap off the page at you.

The Agile Managers Guide to Understanding Financial Statements

is your guide. Youll learn what the most-used financial state-

ments are and what they tell you. Youll learn useful ratios that

will enable you to analyze your operations and improve them.

Youll learn how to assess the financial health of your company,

an important skill as companies come and go faster than ever.And youll attract the notice of higher-ups, who tend to pro-

mote those who understand the profit motive and use the lan-

guage of numbers.

Best of all, youll acquire peace of mind. Youll see that num-

bers arent scary things, that theyre simply another language

that sheds light on business operations. And that speaking in the

language of numbers is none too difficult to learn.You can read Understanding Financial Statements in one or two

sittings, then refer to it again and again as you need to. The

contents, glossary, and indexand the Best Tips and Agile

Managers Checklist boxesmake it easy to find what youre

looking for.

In short, The Agile Managers Guide to Understanding Financial

Statementswill help you get maximum benefits in your job andcareer with the least amount of effort.


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9

I dont know. Its a mysterious thing.ROGERSMITH, FORMERGENERALMOTORSCHAIRMAN(WHENASKED

BYFORTUNETOEXPLAINTHECAUSEOFGMSFINANCIALWOES)

Here you go, partner, said the Agile Manager to Steve, hisassistant, as a he threw a small stack of stapled sheets on the desk.

Steve looked up quizzically. The quarterlies. Theres a note foryou on top.The quarterly whats? asked Steve as he looked down and

saw rows of numbers on the top page.Our quarterly financial statements, responded the Agile Man-

ager. He had meant only to toss them on the desk as he strode by,but now he laid his clipboard down and leaned toward Steve. Ineed you to calculate a few ratios for me before Wednesdaysdepartment meeting.

Steves heart began to pound and his face turned red. The AgileManager noticed and said, Whats the big deal? You have anMBA, right?

Who told you that? I was an English major.

Chapter One

Financial Statements:Who Needs Them


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The Agile Managers jaw dropped slightly. Hed inherited Stevefrom his predecessor, and he couldnt be happier with Steves or-

ganizational skills and business sense, especially his insight intomarkets and the psychology buyers bring to it. Youre kidding,he said.

No. Steve didnt know whether to laugh or remain stone-faced.So what do you know about financial statements?Nothing. And Im scared to death of numbers, he added. I

dont seem to understand them. And he thought, Im even moreafraid of people finding that out . . .

Good! said the Agile Manager, brightening. Together wellface that fear and youll be a better man because of it. And moreuseful to me. We start tomorrow at 9:00 A.M.

After the Agile Manager left, Steve was glum. He thought, Whyme? You dont need financial statements to understand business,anyway. Or do you?

Who needs financial statements? You, for starters, and for anumber of good reasons. But well get back to that in a moment.

Plenty of other parties have a keen interest in what these odd

documents have to say, so lets get them out of the way now.

Well save the bestwhats in it for youfor last.

Several groups of people have a vested interest in a companys

financial statements. They include:

1. Management. Financial statements show the essence ofmanagements competence and the sum total (pun intended) of

its success. Top managers may be able to hide behind the tinted

windows of stretch limos and armies of flunkies and assistants,

but the results of their decisionsand whether theyve made or

lost money for the companywill show up on its financial state-

ments. They can run from the numbers, but they cant hide.

2. Stockholders. Ever bought stock in a company becausethe CEO dressed nicely or its products claimed to improve your

sex life? Probably not. More than likely, you bought stock be-

cause the company had a history of solid financial performance.

Or, if it was a new business, because you or your stockbroker


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11Financial Statements: Who Needs Them

BestTipWhen you can read financialstatements, you wont be to-tally dependent on the adviceof stockbrokers or your depart-ments bean counter.

believed it would make some serious money down the road.

How could you tell? By what it reported on its financial state-

ments, of course. They reveal both past performance and futurepotential. (And as Charlie Brown once observed, Theres no

heavier burden than a great potential.) So we invest in the pos-

sibilities that we uncover on the statements and bail out when

the statements signal inept management or a dim future. The

former usually precedes the latter.

Stockholders who dont understand financial statements end

up relying solely on a stockbrokers advice. That puts them at adisadvantage. They dont understand what the broker is talking

about, they cant interpret the companys annual report (although

the photographs probably look pretty), and they cant ask intel-

ligent questions and make in-

formed decisions about whether

to buy or sell. (One clue to cor-

porate trouble anyone can under-stand: The worse shape a business

is in, the more flashy its annual

report usually looks.)

3. Present and potential

creditors.These include bond-

holders, suppliers, commercial

banks that may give the company a line of credit, landlords, andanyone else the company might end up owing money to.

Creditors that have loaned money to a company with one

foot in the grave, or sold stuff to it on account, usually wont

throw good money after bad. Theyll ask to see financial state-

ments if they suspect trouble. If theyre really nervous, they may

also demand more collateral (security) for the loans theyve made

already.One creditor reportedly made quite an exception for real-

estate developer Donald Trump, though.

Back when The Donald was in a bit of a bind, his chief num-

ber-cruncher managed to convince a major bank that had loaned


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him money to pay the six-figure insurance premiums on the

Trump Princess, a yacht. Trumps minion argued that Donald

couldnt afford em, and if the insurance lapsed and the yachtwere destroyed, the bank would lose a major chunk of collateral.

So wouldnt it be smart to pay the insurance? The bank did.

(Note: Trump is a professional. Dont try this technique yourself.)

Potential creditors want to verify that the business is in good

shape and evaluate how much debt it can safely shoulder before

they commit themselves. After theyve made the loan or given

the company an open-book account, theyll demand, naturally,to see future financial statements to confirm that the company

is staying afloat.

How important is it to be able to read financial statements?

Consider this. A graduate student who was working on his

masters degree in accounting was sent out by a professor to

help a panicky small-business owner who was about to go belly-

up. The guys suppliers had cut off his credit the day they saw hislatest balance sheet. He had no idea why.

The student looked at the balance sheet (something youll

learn about in chapter three) and discovered a terrible mistake.

The CPA who prepared the statement for the naive owner had

mistakenly classified the companys $200,000 mortgage balance

which had twenty years to runas a current liability. That meant

it had to be paid within a year. When the suppliers saw thisenormous debt supposedly due within the next twelve months,

they cut off the companys credit in a New York minute.

When the student confronted the errant CPA with his mis-

take, he harrumphed, muttered, and briskly ushered the lad out

of the office.

The problem was eventually straightened out, and the badly

shaken entrepreneur learned a valuable lesson: Owners need toknow enough about their companies statements to read them

critically and understand what theyre reading, because creditors

sure do.

4. Unions.Before contract negotiations come around, unions


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analyze a companys financial statements to find evidence of poor

management, mismanagement, good management, and anything

else that might be used as levers in the bargaining process. (Topexecutives salaries inevitably take a hit, but the size of their

bank accounts cushions the blow.)

Financial-statement informa-

tion sometimes shows union rep-

resentatives where management

might find money to pay higher

wages and/or better benefits, soyou can bet your bottom line that

a unions financial wizards really

take the statements apart. And

those guys dont wear hard hats, carry lunch pails, and play touch

football. They wear suits, carry laptop computers, and play hard-

ball (around the bargaining table).

5. Government.Laws and regulations require companies toreport various financial information to several levels of govern-

ment and associated agencies and bureaus. Its a necessary evil if

you want to stay in business. Certain taxes are based on the

value of what a company owns, too. And then theres our fr iend

the Internal Revenue Service. Enough said?

Whats in It for YouWhy should youcare about financial statements? Because you

probably enjoy eating and living indoors. But more specifically: You can relieve your anxiety about your company going

bankrupt (or bail out early) by reading its statements. You can

also track its financial performance, which has a major impact

on the value of your stock options, 401(k) plans, profit-sharing

programs, and how much expensive art work top managementcan buy to decorate the executive suite.

Statements also confirm whether all that downsizing really

made as much difference in the companys performance as the

boss promised it would.

BestTipOwners: Dont rely solely onyour accountant to paint a

picture of your companysfinancial condition.


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Youll learn to make and defend your proposals in dollars

and cents. Ditto requests for more and better equipment to run

your department, division, or team. And those proposals, no matterwhat management level youre on, will all have some bearing on

your companys financial health. Youll learn to speak a new language. Higher managements

goals are usually expressed in dollars, and theyre relayed down

the ladder to the rank and file. Thats why accounting has been

called the language of business. Agile managers must be rea-

sonably fluent in it. Youll understand financial

statements and their own pecu-

liar (but not awfully difficult) jar-

gon. That helps you communi-

cate at a higher, more professional

level.

This ability tends to level theplaying field when you have to

communicate with full-time

number-crunchers and bean counters who may otherwise try

to dazzle you with footwork. A working knowledge of their

vocabulary insulates you from being snowed by it and may even

help you start a blizzard or two of your own.

Youll improve your reputation. Speaking in financial termswhen the occasion calls for it gives you a reputation as a bot-

tom line manager, which higher managers will warm to like a

cold dog to a hot stove.

Youll be prepared to analyze, interpret, and challenge some

of the numbers that peers and superiors toss around(especially

when they think they can monopolize the meeting).

You can compare past, present, and projected financial state-ments from internal profit centers, track important changes from

one financial period to the next, and be ready to supply reasons

for those changes before someone tries to skewer you across a

conference table.

BestTipWhen you learn to speak inthe language of numbers,youll be speaking the lan-guage senior managers knowand like best.


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The Agile Managers Checklist

You need to understand financial statements to:

Analyze the ability of customers to pay you back; Assess the ability of your organization to stay afloat; Defend your proposals to higher management; Gain a reputation as a bottom line manager.

Use financial statements to compare your operationswith those of competitors or benchmark organizations.

Understand numbers. Youll climb the ladder faster.

You can contrast your companys operations with outside

benchmark organizations. That can clarify your relative per-

formance and the reasons behind it. You can also compare yourown area (department, division, or whatever) with other inter-

nal areas, assuming youre all set up as profit centers that make

and sell some product or service.

Youll be able to evaluate the financial fitness of another

company that makes you an attractive job offeran offer that

may not look so great once youve scrutinized the businesss

finances. Who wants to sign on to rearrange deck chairs on theTitanic?

Finally, if you understand what financial statements tell you,

you can rule out one more thing that your esteemed colleagues

might blindside you with when youre jousting for promotions

and raises. People dont mess with those who understand num-

bers. Agile managers uncomplicate their lives as much as pos-

sible because they learnas much as possible. And that helps themscale that organization chart faster than a lizard up a palm tree.


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17

There was an accountant named WayneWhose theories were somewhat insane

With sales in recession

He felt an obsession

To prove that a loss was a gain.

ANONYMOUS

It was just before 9:00 A.M. As the Agile Manager waited forSteve to show up, his mind wandered back to a college account-ing class in which a graduate student did most of the teaching.

During a grueling question-and-answer session, the teacher hadsaid, What are you, a bunch of morons? If you cant understand costof goods sold, I cant wait until you get to inventory valuation.

A friend of the Agile Managers spoke up: You make it seemlike this stuff is logical. Its not. When youre buying componentsfor a product youre making, why shouldnt you be able to deductthe cost from your revenues right away instead of waiting until theproduct gets sold?

Chapter Two

Understand

The Income Statement


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Because, sputtered the graduate assistant, thats the way it is.You cant deduct it until its sold.

Yeah, said another student looking at the questioner. Didntyou know that Moses came down off the mountain with the Gener-ally Accepted Accounting Principles?

As the class exploded in laughter, the graduate student shookhis head and walked out.

It was then that the Agile Manager realized that financial state-ments were made up of a lot more than numbers. They were alsomade up of tradition, archaic policy, law, and idiosyncrasies. Know-

ing that somehow made understanding them easier.

Whats an income statement? Glad you asked. Its an account-

ing statement that summarizes a companys sales, the cost of goods

sold, expenses, and profit or loss (plus a few other items thrown

in for good measure). Although its often called a consolidated

earnings statement, plain folks usually call it an income statement.

What the Income Statement Covers

The income statement covers a particular period of time. A

company always publishes an annual income statement as part

of its yearly report to stockholders. That report also contains

two other statements, the balance sheet and statement of cash

flows. (Well get to those in chapters three and four.)

Companies also produce income statements for shorter peri-ods, such as a month or a quarter. They send quarterly state-

ments to stockholders to update them about the companys per-

formance between annual reports.

Quarterly statements are important because they permit man-

agement to stay on top of things. If a company produced an

income statement only once a year, it could get into a financial

jamand not know until it was too late.

What an Income Statement Shows

When you look at an income statement youll see: Net sales


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19Understand the Income Statement

The cost of the goods that were sold. This information

shows up on income statements for manufacturing, whole-

saling, and retailing firms, because they buy stuff to resell at

a profit. A company that provides only services (consult-

ing, financial planning, or writing computer code, for ex-

ample) wouldnt have a cost of goods sold item on its in-

come statement. Gross profit (Net sales cost of goods sold = gross profit)

Operating expenses (what management spent to run the

company during the period that the income statement cov-ers)

Earnings before income tax Income tax Net income (if youre lucky or good, or both)

Earnings per share of common stock

The skeleton of an income statement, then, looks like this:

Net Sales

Cost of goods sold

Gross profit

Operating expenses

Earnings before income tax

Income tax

= Net income or (Net loss). . . and earnings per share of common stock.

Net income is the fabled bottom line that you hear men-

tioned so often (as in, Whats the bottom line on your proposal

to replace all our employees with computers, Smedley?).

Needed: Lots More Detail

Management and the other interested parties that you readabout in chapter one (including you) need lots more detail than

this skeleton shows.

Figure 2-1 on page 22 shows a fictitious income statement

for a company well call Avaricious Industries. Its a modest little


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firm that, if it lives up to its mission statement, hopes to control

every aspect of your life someday.

To create a detailed income statement, useful for internal re-porting and control, A.I.s accounting department and manage-

ment information systems would compile detailed information

in categories like:

Gross sales, sales returns and allowances, and sales discounts

that went to produce net sales. Information about the methods that were used to value

inventory and calculate depreciation on machinery and

equipment. Individual balances for each of the selling and general-and-

administrative expense accounts. Management needs to track

the changes in each account from one period to the next

and decide whether a particular expense is getting out of

control or if the company should spend more money to

meet marketing challenges from competitors.

A.I.s income statement as shown here is relatively simple for

a company its size. It would also have a version for internal use

that lists every expense account and greater detail in areas like

cost of goods sold.

A Word About Accounting Jargon

When it comes to jargon, accountinglike data processing,

law, and other highly specialized areashas its own. Pity. You

have to get used to the fact that several different terms mean the

same thing or refer to the same idea. This can drive you nuts

unless youve been forewarned.

So, while not putting too fine a point on it:

Revenue and sales are used synonymously. Accountants mayprefer revenue because it sounds more impressive and helps

them defend billing $100 an hour. Profit, net income, and earnings all refer to how much

money the company made.


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Inventory, merchandise, and goods all mean about the same

thing: stuff the company bought and intends to sell to cus-

tomers for a profit. When accountants speak casually (an event so moving that

it merits immortalization in

a Normal Rockwell print),

they may call an income

statement a profit and loss

or P&L statement. Thats

because it indeed showswhether the company made

a profit or a loss.

Lists or summaries of things

like expenses or equipment are typically referred to as state-

ments or schedules. Just dont try to read one to find out

when the next bus runs.

Accountants never just do or make out these statementsor schedules. Heavens, no. Theyprepare them. It sounds much

more dignified, mystical, and professionaland beyond the

reach of mere mortals. And they never charge you money.

They havefeesfor which they send statements for services

rendered. All these discreet euphemisms sound genteel and

politically correct, but its easy to see past the smoke screen.

A Closer Look

So much for an overall view. Climb up on your stool, don

your green eyeshade, and lets have a close-up look at Figure 2-1.

Net sales (or revenue).As mentioned, this is what was really

sold after customers returns, sales discounts, and other allow-

ances were taken away from gross sales. Companies usually just

show the net sales amount on their income statements and dontbother to show returns, allowances, and the like.

Cost of goods sold.This usually appears as one amount on

an annual report, but it takes a little figuring to come up with.

Lets see how we arrived at the numbers by taking a closer look:

BestTipDont look for detail on anincome statement. Account

balances are often condensedand summarized.


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Figure 2-1

Avaricious IndustriesConsolidated Earnings Statement

For Year Ended December 31, 19XX

Net sales $38,028,500Cost of goods sold:

Inventory, January 1 4,190,000

Purchases (net) 25,418,500Goods available for sale 29,608,500Less inventory, December 31 3,250,000

Cost of goods sold: 26,358,500

Gross profit 11,670,000

Operating expensesSelling:

Sales salaries expense 1,991,360Advertising expense 3,527,650Sales promotion expense 987,745Depreciation expense

selling equipment 403,850 6,910,605General and administrative:

Office salaries expense 1,124,650Repairs expense 112,655Utilities expense 39,700Insurance expense 48,780Equipment expense 63,750Interest expense 211,020Misc. expenses 650,100Depreciation expense

office equipment 73,900 2,324,555

Total operating expenses 9,235,160

Earnings before income tax 2,434,840Income tax 925,239

Net income $1,509,601

Common stock shares outstanding: 2,500,000Earnings per share of common stock: $0.60


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Inventory, January 1 $4,190,000Purchases (net) 25,418,500Goods available for sale 29,608,500Less inventory, December 31 3,250,000

Cost of goods sold: $26,358,500

The January 1 inventory was the goods that Avaricious started

the year with, but the company bought lots more to resell dur-

ing the year. Again, details such as purchases returns and allow-

ances may be omitted, so just the net amount of purchases shows

up on the statement.

New purchases are added to the beginning inventory to getthe dollar amount of goods available for sale. Thats what the

company paid for everything it could have sold this year if it

were down to the bare shelves. But its not; it has an inventory of

goods still on the shelves on December 31. When that ending

inventory is subtracted from goods available for sale, Bingo! Youve

got the cost of goods sold.

Note: Avaricious Industries isfor nowa distributor. It buysfinished goods and resells them to retail stores and individuals.

But Avaricious hopes one day to live up to its name and actually

make things. When that happens, its cost of goods sold will be

made up of purchases of raw materials, finished components,

and a bunch of other things like the labor that goes into pro-

ducing what it makes.

Gross profit.How much the company made before expensesand taxes are taken away.

Operating expenses.This section of the income statement adds

up how much money was spent to run the company this year.

Selling expenses include everything spent to run the sales end

of the business, like sales salaries, travel, meals and lodging for

salespeople, and advertising.

General-and-administrative expenses are the total amountspent to run the non-sales part of the company. These expenses

include rent, office salaries, interest on loans, depreciation, and

any other non-sales expenses such as renting stretch limos and

chauffeurs for top managers.


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Earnings before income tax.This is the profit the company

made before income taxes (sob).

Income tax. What the company had better have paid theIRS if it wants to stay in business.

Net income.(Bet you thought wed never get here.) This is

the profit the company made after all the dust clears. If the busi-

ness lostmoney (a thought that makes accountants break out in

hives), this line would be labeled Net loss, and several scape-

goat middle managers would probably be flogged publicly in

front of the fountain at corporate headquarters.Earnings per share of common stock.Youll find out more

about this item when we get to

financial analysis and start uncov-

ering hidden information on the

statements. For now, lets just di-

vide the net income by the num-

ber of shares of common stockthe company has sold (shares

outstanding).

The higher earnings per share are, the more spectacular job

management is doing running your companyif you own

shares. (Just dont ask to borrow that stretch limo for the week-

end. Your picture will show up in the executive dining room as

Moron Stockholder of the Month.)

A Note About Notes

Every annual report has several pages of notes at the end.

These discuss finer points about its operations and accounting

techniques.

Such notes would explain which methods were applied to

calculate certain items, the Generally Accepted Accounting Prin-ciples (GAAP) followed, and a variety of other arcane informa-

tion that may contain some real eye-opening facts if you can

read them without falling asleep. Good luck!

For example:

BestTipRead the notes in an annualreport. Thats where thebodies are buried.


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An income statement covers a period of time, like aquarter or a year. By subtracting various expenses fromsales, it reveals the fabled bottom line.

Revenue and sales are synonymous. So are netincome, profit, and earnings.

Gross profit is sales minus cost of goods sold. Net profit(or net income) is gross profit minus expenses and taxes.

1. Notes might point out that 20 percent of this years sales

are the proceeds from selling off one of the Picasso paintings in

the boardroom. Such one-shot deals/isolated or unusual trans-actions may make the companys financial condition look better

or worse than it normally would.

2. Notes may also reveal information about lease contracts

for facilities or office equipment (which may require payments

of several million dollars a year) that the company has agreed to

pay for the next few years. This information may have a major

impact on future profits if sales decline or the annual paymentsare scheduled to escalate.

3. Notes should disclose if the company has been named as a

defendant in any product-liability, environmental-pollution, an-

titrust, or patent-infringement lawsuits. They should also discuss

its likely exposure (how much of its shirt the company may

lose, including attorneys fees) if the other side wins. In these

cases, the notes should also discuss what amount of the potentialloss is covered by insurance and whether losing the case would

have a material adverse affect (as its sometimes called) on the

companys financial condition.


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27

Chapter Three

Understand

The Balance Sheet

Old accountants never die; they just lose their balance.ANONYMOUS

The Agile Manager reflected on his lessons with Steve. Daysone and two had been a bit rough. It took the first day just to weardown his resistance to numbers in general, and the second day for

him to be able to define, acceptably, things like cost of goodssold. He was dreading todays session, in which theyd tackle thebalance sheet.

But it went better than he thought. Towards the end of the ses-sion, Steve punched a few numbers into a calculator. So the bookvalue of the company is $24 per share. Equity divided by thenumber of shares, right? He looked up. The Agile Manager nod-ded. But our stock price is $79. How can that be?

Aha! You know the stock price. You cant be too oblivious tonumbers. The Agile Manager jabbed Steve in the ribs playfully.

Of course I do, said Steve. A good part of my retirement planis invested in the companys stock.


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Best

TipThe balance sheet freezes thecompanys account balancesat a single point in time. Thebalance sheet can be obso-lete the very next day.

The Agile Manager said, Market price is usually higher thanbook value. Thats the way it is with a publicly traded company. In

our case, people arent buying shares in what we have. They arebuying shares in what they think we will become in the futureabigger company with increasing revenues and profits.

Still, said Steve, book value bears some relationship to mar-ket value, dont you think? If only as a reference point?

Yep. And you know what? Youre already starting to talk likean old pro . . .

A balance sheet fleshes out what accountants call the basic

accounting equation:

ASSETS= LIABILITIES+ OWNERSEQUITY

Each part of this equation can be defined simply:

Assetsare anything of value that a company owns, like cash,

accounts receivable, inventory, buildings, or equipment.

Liabilities are what the company owes to creditors. In plainlanguage, theyre debts. But referring to them as liabilities

sounds more weighty and profound and helps accountants pol-

ish their erudite image as they bill you $100 per hour to inter-

pret this stuff. (Liabilities? Well, we . . . [ahem] we might think

of them as financial obligations

of the firm. Theyre amounts, that

is, sums of money, that the com-pany owes to outside parties. I

suppose you might call them

debts. Thatll be $100.)

Owners equity (or net worth)is the

stake or interest that the owners

have in the company. In a corpo-

ration, owners equity is calledstockholders equity. If the company is a partnership, it would be

partners equity. If the business is a sole proprietorship (which

means its owned by one guy or gal), owners equity could also

be called capital or net worth. Remember what we said back in


29/96

29Understand the Balance Sheet

BestTip

A service business will mostlikely not have an inventory ofany of value.

chapter two about several accounting terms meaning the same

thing? Told ya!

Balance Sheet: Distinguishing Features

What makes a balance sheet different from an income state-

ment? For one thing, it doesnt

summarize information for cer-

tain accounts as the income state-

ment does.

Rather, a balance sheet is asnapshot statement. The com-

pany is frozen on the date shown

at the top, and the balances in its

balance sheet accounts are shown on that specific day typi-

cally the last day of the month or year.

Most of the accounts on a balance sheet have at least one

thing in common: Their balances fluctuate a little bit every daybecause of the days business activities. Also, the balances in a

companys balance sheet accounts run perpetually. In contrast,

the balances in the income statement accounts (sales, expenses,

purchases, and freight, for example) are reset to zero or closed

out at the beginning of the new financial year.

Figure 3-1 on the following page shows the balance sheet for

Avaricious Industries.

Up Close and Personal With a Balance Sheet

Lets carve out the main sections of A.I.s balance sheet and

look at them closer.

Assets.Again, these are anything of value that the company

owns. That includes cash, accounts receivable from customers

that the business has sold to on credit, the coffee machine thatsalways breaking down in the break room, and that $2 million

Picasso hanging in the CEOs office. Assets are typically broken

down into current assets and property and equipment.

Current assets are cash, things that will be converted into cash


30/96


Avaricious IndustriesBalance Sheet

December 31, 19XX

ASSETSCurrent assets

Cash and cash equivalents $1,271,231Accounts receivable 1,032,409

less allowance fordoubtful accounts 38,000 994,409

Notes receivable 350,000

Merchandise inventories 3,250,000Total current assets 5,865,640

Property and equipment 17,841,980Less accumulated depreciation 4,173,130

Net property and equipment 13,668,850

TOTAL ASSETS $19,534,490

LIABILITIESCurrent liabilities

Accounts payable 1,275,300Salaries payable 330,000Income taxes payable 925,239Other accrued expenses 8,000

Total current liabilities 2,538,539

Long-term liabilitiesMortgage payable 500,000Bonds payable 2,400,000

Total long-term liabilities 2,900,000

TOTAL LIABILITIES 5,438,539

STOCKHOLDERS EQUITY

Common stock, 2,500,000 sharesat $1 par value per share 2,500,000

Capital in excess of par value 1,750,000Retained earnings, January 1, 8,386,350

Net income for year 1,509,601

Less dividends (50,000)Retained earnings, December 31, 19xx 9,845,951

TOTAL STOCKHOLDERS EQUITY 14,095,951

TOTAL LIABILITIES AND STOCKHOLDERS EQUITY $19,534,490

Figure 3-1


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within a year (such as accounts receivable and the current por-

tion of any notes receivable), and inventory, which turns into

cash when its sold. Keep looking at the asset section of thebalance sheet as we investigate these items in detail.

Cash and cash equivalents.This is the balance in the companys

checking account(s), plus highly liquid short-term or tempo-

rary investments (sometimes called marketable securities). These

might include certificates of deposit, stocks, and corporate or

U.S. government bonds, all investments that the company could

probably sell with a telephone call to its bank or brokerage firm.They were initially bought to keep excess cash working instead

of leaving it to gather dust in a non-interest-bearing checking

account.

Accounts receivable and notes receivable.Accounts receivable are

owed to the company by customers to which it sold goods or

services on credit. Notes receivable are promissory notes that

the company will collect in less than a year. (Notes receivabledue in more than a year would be listed as a long-term asset.)

Notice that the total accounts receivable balance is reduced

by an allowance for doubtful accounts. Thats the accountants

practical side at work, telling you that the business probably wont

collect allof those accounts.

In a big business that has literally hundreds if not thousands

of credit customers, some will inevitably turn out to be dead-beats or go bankrupt. So the accountants estimate what per-

centage of the companys receivables will turn sour and subtract

that amount. The result is a realistic net amount that the com-

pany expects (crossing its fingers) to collect.

Merchandise inventories.If the company is a retailing or whole-

saling business, this is the value of products that the company

has bought and intends to resell for a profit. In a manufacturingbusiness, inventories include finished goods that are sitting in

the warehouse as well as goods in process (those in various stages

of completion), raw materials, and parts and components that

will go into the end product.


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Best

TipLiabilities and stockholdersequity represent claims againsta companys assets. Thats whythe balance sheet balances.

You can calculate the value of a companys inventory using

one of four methods. Sit tight; therell be more about this in

chapter six.The second category of assets, property and equipment, are,

well, property and equipment. The business uses them to make

the product or provide the service that it sells.

Land, buildings, machinery, and equipment fall under this head-

ing. Theyre shown at the cost the

company paid to buy or build

them (including such expenses asinstallation costs and taxes) mi-

nus the amount that theyve de-

preciated since they were bought

or built.

Depreciation can be plain old

wear-and-tear, technological ob-

solescencethe kind that makes the computer you paid $3,500for last year worth $800 todayor both.

Land isnt depreciated, by the way, because you never use it

up and they arent making any more of it. Raw land is shown on

the balance sheet at its purchase price and neither appraised nor

depreciated as years go by. If the land and the building are even-

tually sold, the difference between the lands cost and what was

received on the sale would be recorded as a gain (if greater thancost) or loss (if less than cost) on sale of plant and equipment.

Some companies may have other categories of assets too, in-

cluding intangible assets such as patents and copyrights. Current

assets and P&E are the two major players, however.

Liabilities.This section, which well reproduce here as Fig-

ure 3-2 to save you from having to flip back a page, shows all the

debts the company owes to creditors of every kind. Even em-ployees are creditors of the company on the balance sheet date,

because it owes them salaries that wont be paid until payday.

Current liabilities are bills the company must pay within the

next twelve months. Long-term liabilities are bills that will come


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due in more than one year. As Figure 3-2 shows, A.I. owes

$500,000 on a mortgage and $2,400,000 on bonds that it sold

to raise funds. Total liabilities? Almost $5.5 million.

Stockholders Equity. This section shows what the company

is worth to its ownersthose optimistic, hopeful stockholders,including widows, orphans, and retirees living on Social Secu-

rity, who risked their life savings to cast their lot with the future

of Avaricious Industries.

As Figure 3-3 shows, Avaricious Industries has sold 2,500,000

shares of stock. Management used the money it got from stock

sales (along with what it borrowed by issuing bonds) first to

start and then expand the business.Youll notice that A.I.s stock has a par value of $1.00 per

share. Thats an arbitrary figure that has nothing to do with what

Figure 3-2

Current LiabilitiesAccounts payable $1,275,300Salaries payable 330,000Income taxes payable 925,239Other accrued expenses 8,000



Total long-term liabilities 2,900,000TOTAL LIABILITIES $5,438,539

Figure 3-3



Net income for year 1,509,601Less dividends (50,000)Retained earnings,

December 31, 19xx 9,845,951TOTAL STOCKHOLDERS EQUITY $14,095,951


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the stock is selling for right now on the open market. While its

customary to assign a par value to stock, as A.I. did, the number

doesnt have much meaning. Its a relic from the pre-Depressionera, when stock had to be sold at

its par value.

Securities regulations nonethe-

less still require par value to be

accounted for separately from

other types of additional paid-in

capital, which is why A.I.s bal-ance sheet carries an account

called capital in excess of par

value. Because A.I. sold some of its stock for more than the

$1.00 par value per share, the excess is shown in that account.

Then there are retained earnings, the profits A.I.s manage-

ment has plowed back into the business over the years. Last

Januarys retained earnings, plus the net income or profit thatthe company made this year (which is carried over here from

the income statement), minus dividends, equals the retained earn-

ings on the balance sheet date of December 31. And when you

add in the par value of its common stock and the capital re-

ceived in excess of par, you have the total stockholders equity.

A Balancing ActAs Figure 3-1 shows, the balance sheet really does balance.

That is, A.I.s total assets equal the sum of the creditors claims

against them (liabilities) and the stockholders claims against them

(the owners or stockholders equity). The balance sheet, in fact,

always balances, even when liabilities exceed assets. In that case,

equity is a negative numberand the company is dead or close

to it, barr ing an infusion of capital.Theoretically, if Avaricious Industries were sold today, the sale

would bring in $19,534,490. Creditors would be paid $5,438,539

to take a hike, and the stockholders would divvy up the remain-

ing $14,095,951 (or $5.64 per share) among themselves.

BestTipDont even try to figure outwhat relation par value hasto anything. Accountants havea hard time explaining it!


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Theory and reality are two different things, however, so the

sale could bring in quite a bit more moneyor quite a bit less.

A selling price depends on the industry, long-term profitability,the companys prospects, and a host of other concerns to buyers.


A balance sheet is a one-day snapshot of the com-

panys assets, debts, and owners equity. A balance sheet shows assets (what the company owns)

and sets them equal to its liabilities (what the companyowes) plus the owners equity in the business.

Theoretically, stockholders equity is what the stockhold-ers would collect if the company were sold on thebalance sheet date.

Retained earnings on December 31 is last years re-

tained earnings plus this years net income.


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37/96

37

If your outgo exceeds your inflow, then yourupkeep will be your downfall.

ANONYMOUS

Now were getting into it, Stevie, said the Agile Managerrubbing his hands together. Cash flow is what its all about. If

cash flow is healthy, it covers a lot of sins.I dont get it. Doesnt every company have a lot of cash flowing

in and out of it?Yeah, but cash flow usually refers to the excess of cash coming

in over the cash going out. It means you have cash in the bank topay bills, fund initiatives, sock a little away for a rainy day, and soonno matter what your income statement says about your prof-its. The Agile Manager leaned back.

I once worked for a company that didnt make a profit fiveyears in a row, he said. But the owner never missed her yearlytrip to Bermuda, and she leased a Benz every two years. And wewere all paid well and had good equipment to work with.

Chapter Four

Understand

The Cash-Flow Statement


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BestTipThe income statement andbalance sheet dont tell you asmuch as you need to know

about your financial position.

But howd she do it? Steve interjected excitedly.Great cash flow. She was absolutely brilliant at timing income

with outflow. When one product was selling great, shed shovelthe cash into R&D and product development. When nothing washappening, shed lay low for a while and cut back on expenses.She also had a pretty sharp accountant who knew how to spreadlosses around, as well as a few other tricksall legalfor reduc-ing the profit.

But isnt profit good?Its necessary, especially for publicly held companies. But profit

is one of those things that can be manipulated up or down. Andsole owners tend to like it down, so they dont have to pay taxeson it. He straightened up again.

Your cash flow, however, never lies. Let me show you what Imean . . .

A cash-flow statement shows where the companys cash came

from (sources of cash) and where it went (uses of cash). Like anincome statement, the cash-flow

statement covers a block of time,

such as a month or year. Avari-

cious Industries cash-flow state-

ment appears in Figure 4-1 on the

following page.

As youll see, net income isonly the starting point for figur-

ing out actual cash on hand at the

end of the year.

Cash Flow: Its a Big Deal

As our whimsical opening quote implies, a companys cash

flow deserves plenty of attention. There are cases of companiesthat had millions of dollars in noncash assetsand profitability

on paperbut which had to close down because they couldnt

keep enough cash on hand to pay their regular monthly bills

and run the company day to day.


39/96

39Understand the Cash-Flow Statement

Businesses, like people, sometimes spend recklessly, anticipate

sales from uncertain sources such as landing that big contract

(the corporate version of winning the lottery), expect rapid pay-

ment of accounts receivable (ha), and otherwise live beyond their

means.

Businesses sometimes also pay too much attention to their

income statements to make decisions. That can be dangerous,because virtually all corporations keep their books on an ac-

crual basis. This means they record income when they make

the sale, and not when they receive the cash. Similarly, they record

expenses when they incur them, not when they pay them. (Re-

Figure 4-1Avaricious Industries

Cash Flow StatementFor Year Ended December 31, 19XX

Cash flows from operations:Net income $1,509,601

Adjustments to reconcile net income to net cashIncrease in accounts receivable (221,275)Decrease in inventories 940,000Increase in notes receivable (30,000)

Decrease in accounts payable (202,500)Depreciation on equipment 477,750

Net cash provided by operations 2,473,576

Cash flows from investing activitiesPurchase of property and equipment (2,080,695)Proceeds from sale of equipment 160,000Net cash used for investing activities (1,920,695)

Cash flows from financing activitiesSale of common stock 25,000Sale of bonds 65,750Cash dividends paid (50,000)

Net cash inflow from financing activities 40,750Net increase (decrease) in cash 593,631Cash balance, December 31, 19XX (last year) 677,600Cash balance, December 31, 19XX (this year) $1,271,231


40/96


BestTipUse the cash-flow statement toanticipate cash shortages orexcessesmonths before theyhit.

cording income when you receive it and expenses when you

pay them is called cash-based accounting. Its probably how

you manage your home finances.)Thats why a company can be profitable on paper, while strug-

gling to come up with the cash to fund growth or pay bills.

What Its Good For

Because a cash-flow statement shows sources and uses of cash,

it can be used to:

1. Forecast future cash flows. How? Previous cash receiptsand disbursements establish a pattern. Management can use it to

predict where cash is most likely to come from and go to next

year.

2. Show the companys owners and creditors how much man-

agement invested last year in new equipment and facilities. Busi-

nesses need to invest in such state-

of-the-art technology as CAD/CAM, CIM, robotics, and bar-

code inventory tracking sys-

temsnot to mention update

their existing software and hard-

wareto stay on the cutting edge

of productivity and pare operat-

ing costs to the bone. (The slo-gan of companies that dont upgrade their facilities and equip-

ment might be, Answering yesterdays challenges tomorrow or

the next day.)

The cash-flow statement can also be used to confirm whether

a company has enough cash available to pay interest to bond-

holders and dividends to stockholders. If a firm has bonds out-

standing, management will have to contribute enough cash to a

sinking fund each yearan account set up specifically to hold

money used to pay off both bond interest and principal. (Compa-

nies usually invest the money in their sinking funds with the hopes

that they can earn returns good enough to retire bonds early.)


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Dissecting a Cash-flow Statement

Lets take a look at each part of A.I.s cash-flow statement tosee what happened last year.

Cash flows from operations. This section shows how much

cash came into the company and how much went out during

the normal course of business. Figure 4-2 below starts with A.I.s

net profit (the bottom line of the income statement).

Several other aspects of the companys operations either in-

creased or decreased its cash, however, and those are shown un-der the adjustments heading. Generally Accepted Accounting

Principles (GAAPs) as well as logic dictate how these adjust-

ments are made on the cash-flow statement and whether they

increased or decreased the companys supply of cash.

While not venturing too far into the technical forest, lets

look at the adjustments and their consequences.

A.I.s ending accounts receivable balance this year (youll findthat on the balance sheet on page 30) was $221,275 higher than

last years, which acted to decrease its cash balance. The logic

here: An increase in receivables is money earned and reflected

in the net income. But Avaricious doesnt actually have that

money yet, hence the decrease in actual cash on hand.

For the same reason, the increase in the notes receivable bal-

ance also signals a reduction in cash.A decrease in accounts payable balance also decreases cash

Figure 4-2

Cash flows from operations:Net income $1,509,601

Adjustments to reconcile net income to net cashIncrease in accounts receivable (221,275)

Decrease in inventories 940,000Increase in notes receivable (30,000)Decrease in accounts payable (202,500)Depreciation on equipment 477,750

Net cash provided by operations $2,473,576


42/96


because youve used funds to pay down the overall balance in

the account.

The companys ending inventory was $940,000 lower than itsbeginning inventory (youll find both inventory levels on the

income statement on page 22). That acts to free up (increase)

cash previously sitting in inventory.

Since depreciation on equipment didnt physically decrease

the companys cash balanceits only an accounting fiction

accounting rules call for it to be shown as an inflow of cash

from operations.Cash flows from investing activities. Cash may come in

and go out because of various investing activities that arent con-

nected to business as usual.

Figure 4-3 shows that A.I.s management bought more than

$2 million worth of property and equipment (which caused cash

to go out) and sold some obsolete or unneeded equipment (which

brought cash in). The net effect of these investing activities de-creased cash about $1.9 million.

The investment in property and equipment is an investment

in the companys future; it should enhance its competitive posi-

tion. (Lets have a round of applause for proactive management!)

And the inflow from equipment sales was minimal, a good

sign. Unlike some cash-strapped companies, A.I. hasnt been

forced to sell off equipment to cover expenses.A company thats forced to do that is like a sinking ship that

jettisons its cargo to stay afloat. If it survives at all, itll just be an

empty shell that eventually washes up on the rocky shoals of

bankruptcy. There itll be picked clean by beachcombing scav-

engers such as vultures wearing Armani suits and fiddler crabs

Figure 4-3Cash flows from investing activities

Purchase of property and equipment (2,080,695)Proceeds from sale of equipment 160,000Net cash used for investing activities ($1,920,695)


43/96


wearing tiny little IRS Swat Team caps, mirrored sunglasses,

and, of course, white socks (required by their government con-

tract).Cash flows from financing activities. A.I. raised $90,750 in

cash by selling common stock and bonds this year (see Figure

4-4). The company also paid out

$50,000 in cash dividends to

stockholders and ended up with

a net cash inflow of $40,750 from

financing activities.As Figure 4-1 shows, A.I. had

a net increase in cash this year,

and most of its cash came from

operations. Thats good. Healthy

companies are able to meet their

normal cash requirements through operations.

Long-term financing (selling shares of stock or bonds, or get-ting a multi-year loan) should be used to raise funds for acquir-

ing new machinery, equipment, or facilitiesnever to pay daily

business bills.

A negative cash flow from operations means that the com-

pany failed to meet its cash needs. In that case, the company

must lower expenses quickly or raise cash. The notes at the end

of one small corporations annual report discreetly revealed thatit was so hard up for cash that it had borrowed on the cash

surrender value of its life insurance policy on the chief execu-

tive officer!

The final entry on A.I.s cash-flow statement is the ending

Figure 4-4

Cash flows from financing activitiesSale of common stock 25,000Sale of bonds 65,750Cash dividends paid (50,000)

Net cash inflow from financing activities $40,750

BestTipA company that has to rely on

financing activities (such asselling stock or bonds) to sat-isfy most of its cash require-ments is headed for trouble.


44/96


cash balance for the year, which is (no surprise) the same as the

cash balance on the balance sheet.


The cash-flow statement reconciles a companys cashbalance from one year to the next.

The cash-flow statement shows the net cash flow from:

Normal operations; Investing activities, such as buying new equipmentand selling obsolete equipment; Financing activities, such as selling stock or bondsand paying out dividends.

While depreciation is deducted on the income statementto come up with net income, it doesnt decrease the

companys cash. Note how much a company invested in its operations.Its a telling figure.


45/96

45

Chapter Five

Financial Analysis:

Number-Crunching for Profit

Just dropped in to see what condition your condition was in.PARAPHRASEOFLINEFROMAPOPULAR1960SSONG

Besides return on investment for the products this departmentproduces, I like to look at companywide things like sales per em-ployee and return on net assets, said the Agile Manager.

Why bother? said Steve. Dont we have plenty of beancounters at corporate to worry about stuff like that?

I dont care whether we do or not. Its part of my early warningsystem. Tells me about the overall health of the company. If thesales-per-employee figure is slipping, for example, then Im carefulabout requesting funds for a new hire. If the return on assets orequity is declining, I can expect some kind of belt-tightening pro-gram. Its not a question of if, but when.

But how do you know what those numbers mean to the seniormanagers? How do you know what makes em happy or sad?

I dont know for sure. But I suspect theyre doing what I do:Comparing them to figures for our competitors. Look at this, hesaid pulling a sheet from the top drawer of his battered desk. This


46/96


is a list of common ratios for our industry. Its compiled by theMedical Products Manufacturers Association from real numbers. To

be part of the organization, you have to submit financial data.Hmm, said Steve thoughtfully as he gazed at the page. Theaverage sales per employee for a company our size is $322,500.And based on your calculationSteve leaned over to glance atthe Agile Managers yellow padwere at around $375,000.Heybonus city this year, right?

Sureif it were up to me alone, said the Agile Manager chuck-ling. But that figure will benefit you in other ways. I just got the

approval to hire another developer, which will take the load off therest of us. And well be getting a new test bench next month . . .

Most people seem drawn to, indeed,fascinated by, things with

beautiful shapes. Its part of our aesthetic, kinder-gentler-art-

loving side to want to gaze upon visually appealing objects that

speak to and nurture our inner spirit . . . the daring lines of a

Dodge Viper, the breathtaking beauty and simplicity of a tulipin May, or the financial statements of a company that outwardly

seems so rock-solid that it seems to work out twice a day.

But how can you gently str ip away its corporate clothing layer

by layer to reveal whether that company is really in great shape

or just trying to dazzle you with the business version of a face

lift, tummy tuck, Rogaine, or hair transplants?

By reading this chapter, of course!

Liars May Figure, But Figures Dont Lie

Financial analysis is the company version of an annual physi-

cal (cough). Sometimes its called ratio analysis, although some

of the digital checkups well do are ratios and some arent.

Financial analysis can be fun. Dont adjust your glasses; you

read that right. Why fun? Because statements conceal lots ofimportant (and sometimes delightful or terrifying) facts just by

the way theyre laid out. The information isnt all that obvious.

Its not that someones trying to pull a fast one (usually not,

anyway). But eyeballing statements to evaluate a companys con-


47/96

47Financial Analysis: Number-Crunching for Profit

BestTipTheres no best calculationthat answers the question,Hows the business doing?

dition will only give you eyestrain. They dont connect certain

pieces of information the way theyll be connected, related, and

explained in plain language here.Youll notice that we sort of

eased up to the topic of a com-

panys financial fitness casually, as

if we were approaching the firm

in a singles bar. We checked it out

in general from a distance by

ogling the income statement andbalance sheet. Now its time to make a ser ious move.

Take Precautions First

Precautions here means theres no one best calculation you

can do with a companys financial statements that neatly an-

swers the question, Hows the business doing? Some of the

calculations well do may show that its in great shape. Othersmay show its in trouble.

And something else: Most of what youll find out about our

friend Avaricious Industries in this chapter will mean lots more

when stacked up against comparative data from a reliable source.

Comparative data means whats typical for other companies

in the same line of business as A.I. Reliable source can refer to

several possible places: The companys trade association, which should be able to

summarize the average performance for a company in that

particular industry. Dun & Bradstreet, which publishes key ratios for more than

one hundred lines of business each year. Robert Morris AssociatesAnnual Statement Studies, which

examines the annual financial statements of lots and lots ofcompanies of all sizes and in all industries. Your library

should have a copy. (And business owners: Be aware that

your banker will probably check your financial statements

against it when you march in to ask for a loan.)


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BestTip

Most of the information that

financial analysis uncoverstakes on a lot more meaningwhen you compare it withindustry standards.

One more tidbit. Remember that whats considered good per-

formance in one industry may be not so good in another. It

depends on the nature of the business itself. Retailing businesses,for example, are very different creatures from cement producers,

computer manufacturers, or companies that write software. Each

group of animals in the business zoo has distinct norms and

behavior.

Financial Voyeurism

Think of the calculations youre going to learn about as indi-vidual windows you can look through. They are just like the

windows in a house. Each gives you a different view of whats

going on inside, and some views

may be lots more interesting than

others. But no one window in a

house lets you see everything

thats going on inside, just like noone calculation shows you every-

thing thats going on inside a

company. You have to do a num-

ber of them.

So lets play Peeping Tom (fi-

nancially speaking) and see what happens when we peek over

A.I.s corporate window sills. Grab your calculator and comeon!

Analyzing an Income Statement

Here well hark back to Figure 2-1 and pull off whatever

numbers we need. (Its reproduced on the next page.)

Ratio of Net Income to Net Sales. Find this by dividing net

income by net sales:

This ratio tells you how much net income (or profit) a com-

Net income $ 1,509,601

Net sales $38,028,500= = $.04 : $1


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Avaricious IndustriesConsolidated Earnings Statement

For Year Ended December 31, 19XX

Net sales $38,028,500Cost of goods sold:

Inventory, January 1 4,190,000Purchases (net) 25,418,500

Goods available for sale 29,608,500Less inventory, December 31 3,250,000

Cost of goods sold: 26,358,500

Gross profit 11,670,000

Operating expensesSelling:

Sales salaries expense 1,991,360Advertising expense 3,527,650

Sales promotion expense 987,745Depreciation expenseselling equipment 403,850 6,910,605

General and administrative:Office salaries expense 1,124,650Repairs expense 112,655Utilities expense 39,700Insurance expense 48,780Equipment expense 63,750

Interest expense 211,020Misc. expenses 650,100Depreciation expense

office equipment 73,900 2,324,555

Total operating expenses 9,235,160

Earnings before income tax 2,434,840Income tax 925,239

Net income $1,509,601

Common stock shares outstanding: 2,500,000Earnings per share of common stock: $0.60


50/96


pany makes on each $1.00 of net sales. A.I. made 4 cents of net

income on each dollar it collected in net sales. Is that good or

bad? It depends on whats typical for A.I.s industry.In the supermarket industry, two to five cents on each dollar

of net sales is about average year in and year out. Maybe thats

why you see delicatessens, fast-food restaurants, pharmacies,

flower shops, bank branches, and plastic surgery salons now ap-

pearing inside many of the larger supermarkets near you. Those

operations return a higher profit on each dollar of net sales and

make up for the grocery businesss meager profits. (Were onlykidding about the plastic surgery salons, but theyre probably in

the works. Dont forget where you heard the idea first!)

Chipmaker Intel, on the other hand, has been known to make

upwards of 25 cents on each dollar of revenuenow theres an

avaricious industry!

Incidentally, the formula above also yields a figure for some-

thing youve probably heard ofnet profit margin. Its expressedin percentage form. AIs net profit margin is thus 4 percent.

Lets detour here for a moment and use this ratio to make several

points about figuring and understanding ratios in general.

When the ingredients are named in the title (as in ratio of

net income to net sales) put the first item abovethe line

and the second one below. Thats a handy memory key in

case youre ever caught without this book (God forbid!). Once youve set it up, Always divide the lower number

into the upper one.(Put another way, always divide the

upper number by the lower number.) Thats Straubs first

law of ratio math. If you do it the other way, youll be dead

wrong, and full-time financial types will sneer as you walk

past the water cooler.

When you get the answer, write it down and put it theform : $1 because ratios compare one thing to another.

So much for mechanics. Now heres how you interpret any

ratio:


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The first number in your answer always refers to whatever

was above the line (in this case, net income) and the 1 always

refers to whatevers underneath (in this case, net sales).Lots of folks like to express ratios in money instead of bland-

sounding numbers, because people really tend to listen up when-

ever moneys involved. No surprise, huh? So well be talking

ratios in money here.

Now, back to the show.

Ratio of Net Sales to Net Income. This flip-flops the two

ingredients used above, but youll still get some useful informa-tion. A.I.s ratio is:

This ratio tells you that A.I. had to take in $25.19 in net sales

to make a dollar of profit. Thats how hard the company has to

work to make a buck.So if $1.00 out of every $25.19 of net sales ended up as net

income, where did the other $24.19 go? Well, some went to

cover the cost of the goods that were sold, and the rest went to

pay expenses.

Remember now, dont jump to conclusions about any of this

information until you get a comparative figure from a reliable

source. What looks good for a company in one industry may benot so good for a company in a different line of business. Once

you found out what the typical ratio of net income to net sales

was for A.I.s industry, though, youd know if Avaricious had to

work harder or easier than its typical competitor to make a dol-

lar of profit.

Inventory Turnover. This is a theoretical figure. Its the num-

ber of times the company sold out to the bare walls and replacedits average stock of goods this year. A.I.s inventory turnover is:

Net sales $38,028,500

Net income $ 1,509,601= = $25.19 : $1

Cost of goods sold

Average inventory (beginning inventory + ending)/2


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Note that inventory turnover isnt expressed as a ratio, per-

cent, or some other way. Youd simply say that A.I. turned over

its average stock of goods 7.09 timesthis year.

A good turnover figure depends on what line of business

youre in. Jewelry stores, for example, may be lucky to turn over

(sell out) their average inventory once a year. Supermarkets and

health-food stores, which sell per-ishable items, turn over their in-

ventory dozens of times in a year.

Get a comparative figure for your

line of business.

What if turnovers low? A turn-

over thats lower than the indus-

try average may mean the com-pany is carrying too much inven-

tory, trying to sell the wrong stuff, or isnt doing as good a mar-

keting job as its competitors.

Any combination of these situations would lower turnover

and be bad news:

1. If the companys carrying too much inventory, its tying

up money unnecessarily (not to mention storage space and thepeople who keep records). Also, it has to pay interest on the

funds it probably borrowed to pay suppliers.

2. An overstocked inventory means potential trouble if the

company is selling seasonal or fashion merchandise that may be

hard to unload later. (Just try selling snowmobiles in midsum-

mer or marketing bell-bottom slacks or Nehru jackets to todays

youth.)3. Low turnover caused by the wrong selection of inventory

means management may be out of touch with what the companys

customers want to buystubbornly trying to sell them widgets

when they really want gadgets, for example.

BestTipLow turnover often indicatesthat the company has toomuch of the wrong kind ofgoods.

$26,358,500

($4,190,000 + $3,250,000)/2= 7.09 times


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What if turnovers high? A turnover thats higher than the in-

dustry average may mean that the companys doing a better

marketing job than its competitors, and that would be cause tothrow a party. But before management starts sending out invita-

tions, a high turnover could also mean that the business is stock-

ing a lower average inventory than it should and not buying in

large quantities. That could mean three things:

1. Its not getting the highest possible quantity discounts from

suppliers.

2. It may be paying higher freight charges, because buyingoften and in small amounts usually forces you to ship by the

most expensive methods.

3. Its paying too much. When prices are rising (as they usu-

ally are) buying often and in small quantities means youll pay

successively higher prices every time you buy.

So a higher-than-average turnover might be good or bad. Man-

agement wont know which until they check records, searchtheir souls, call a few meetings, and reward or scare the hell out

of whoever might be responsible, depending on the case.

Note: Although wholesalers and retailers must often carry a

large inventory to accommodate the demands of their custom-

ers, manufacturers attempt to keep their inventories at a mini-

mum. The practice of just-in-time inventory management in

manufacturing has produced sizable savings in storage space,materials handling equipment, interest paid on borrowed funds,

and other costs associated with carrying an inventory of materi-

als and parts that go into an end product.

In the case of manufacturers, then, a zillion inventory turns

could mean great things for a company.

Analyzing a Balance SheetNow lets revisit Figure 3-1 (its on the next page) and pull

off whatever numbers we need from there.

Current Ratio. Find this by dividing A.I.s current assets by

its current liabilities.


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Avaricious IndustriesBalance Sheet

December 31, 19XX

ASSETSCurrent assets

Cash and cash equivalents $1,271,231Accounts receivable 1,032,409

less allowance fordoubtful accounts 38,000 994,409

Notes receivable 350,000

Merchandise inventories 3,250,000Total current assets 5,865,640

Property and equipment 17,841,980Less accumulated depreciation 4,173,130

Net property and equipment 13,668,850

TOTAL ASSETS $19,534,490

LIABILITIESCurrent liabilities

Accounts payable 1,275,300Salaries payable 330,000Income taxes payable 925,239Other accrued expenses 8,000



Total long-term liabilities 2,900,000TOTAL LIABILITIES 5,438,539

STOCKHOLDERS EQUITY



Net income for year 1,509,601

Less dividends (50,000)Retained earnings, December 31, 19xx 9,845,951

TOTAL STOCKHOLDERS EQUITY 14,095,951

TOTAL LIABILITIES AND STOCKHOLDERS EQUITY $19,534,490


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The current ratio is a measure of safety. It tells you how manytimes the company could pay its current debts if it used its cur-

rent assets to pay them with.

A.I.s current ratio looks pretty solid. The company has $2.31

in current assets standing behind

each $1 it owes in current debts.

If this ratio were above, say,

$3 : $1, it would imply that man-agement had too many current

assets (perhaps cash or inventory)

that were just sitting there like a

roomful of freeloading relatives

instead of helping to make prof-

its for the stockholders.

A current ratio may give you a false sense of secur ity, though,because it includes some current assets (like inventory, for ex-

ample) that can be hard to get rid of in a hurry if creditors are

breaking down your doors. So a more realistic ratio that high-

lights a companys ability to pay its current bills is the next one.

Acid-test Ratio. The acid-test ratio is:

In A.I.s case, thats

The acid-test ratio shows how well a company could pay its

current debts using only its most liquid or quick assets. This isa more pessimisticbut also realisticmeasure of safety than

the current ratio, because it ignores sluggish, hard-to-liquidate

current assets like inventory and notes receivable.

Instead, it adds up the three most liquid assets a business has:

BestTipThe acid-test ratio is a morerealistic and practical measureof ability to pay current debtsthan the current ratio.

Current assets $5,865,640

Current liabilities $2,538,539= $2.31 : $1=

Cash + Accounts receivable + Marketable securities

Current liabilities

$1,271,231 + $994,409 + $0 $2,265,640

$2,538,539 $2,538,539== $.89 : $1


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cash (which is as liquid as you can get), accounts receivable (which

will probably be collected in a month or so), and marketable

securities (which could probably be sold with a telephone call).A.I. seems to be fairly solid by this measure, too, with 89

cents in highly liquid assets standing behind each $1 it owes in

current debts. If its acid-test ratio was, say, $1.50 : $1 and much

of it was in cash, management might think about putting some

of that cash to work by investing it in facilities or equipment,

enhancing the companys marketing eff

Documents

Finance Management Accounting the Agile Manager's Guide to Understanding Financial Statements